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Ahead of the curve: What's actually going on with inflation?

December 30, 2020

A comment from Jürgen Lukasser, Chief Investment Officer of LGT Bank Österreich, on 2020, that will be long remembered as the year of the Corona pandemic, lock downs, dogged work to make the vaccine as safe as possible, and - like it or not - the widespread rollout of the "home office." It was also a year of fiscal packages and liquidity injections.

Ahead of the curve: What's actually going on with inflation?

The year 2020 is drawing to a close. Thank goodness, many are thinking. 2020 will long be remembered as the year of the Corona pandemic, lock downs, dogged work to make the vaccine as safe as possible, and - like it or not - the widespread rollout of the "home office." From an asset manager's perspective, what remains most memorable is the massive effort on fiscal and monetary policy. States and central banks obviously learned from the 2008 financial crisis and quickly provided fiscal packages and liquidity injections on a large scale. To finance the fiscal stimulus, for example, the U.S. increased U.S. debt to GDP from 105% to about 130% at year-end. This development corresponds to the largest new debt since the outbreak of World War 2. Similar things can be said about the Fed, with both narrow and broad monetary aggregates indicating a massive expansion of the money supply.

At this point, therefore, the question must be asked whether this money supply expansion is causing us headaches because burgeoning inflation is the logical outcome? Milton Friedman - the founder of monetarism would agree with this thought. He argued in his legendary 1956 paper on the subject that inflation is always and everywhere a monetary phenomenon and therefore can be controlled by changing the money supply. Expanding the money supply, as we have seen, therefore sounds like trouble. A look at history, however, provides clues that the connection may be less strong after all, or that there may be other factors to consider. One or the other reader may still remember the situation after the great financial crisis of 2008. A combination of financial and credit crises caused a super-GAU on the financial markets and brought the Western economic system to its limits. Hesitantly, the decision was made on the part of the Federal Reserve to support the functioning of the markets. The solution to the problem was supposed to be the policy of "quantitative easing." In short, bonds were purchased through the market, providing additional liquidity to the economy by increasing the money supply. Even then, the growing money supply was causing worry lines. In this environment, Warren Buffet made headlines with a book recommendation. He recommended reading Times journalist Adam Fergusson's 1975 book, "When Money Dies". An entertaining anecdote in this context is the fact that this book was out of print worldwide at the time and could only be purchased on ebay at outrageous prices in the order of several thousand US dollars. Through the new edition in 2010, this publication is now also available to readers with a smaller wallet.  This work is also particularly interesting from an Austrian perspective, as the phase of hyperinflation is analyzed both in the Weimar Republic and in Austria of the 1st Republic. In fact, since the financial crisis, the expected surge in inflation has completely failed to materialize. There seem to be several reasons for this. On the one hand, it was a combined financial and credit crisis, on the other hand, demographic aspects of globalization as described by former UK central banker Charles Goodhart in his publication "The Great Demographic Reversal" seem to play a role that should not be underestimated.

But let us first turn to the point of the combined financial and credit crisis. The key difference with the current situation is this: there is no credit crunch at present. In the aftermath of the credit crisis, for example, the U.S. Federal Reserve significantly increased the narrowest monetary aggregates M1 - currency and overnight deposits. Broad monetary aggregates such as M3 - all money including debt and securities - were hardly affected by this. At that time, the money did not reach the real economy due to the credit crunch. Currently, the broad money aggregates are also showing a significant increase. Intuitively, this already sounds like inflation.

One interesting aspect in this context is long-term inflation expectations, which are currently priced in by the capital markets. Here, a sharp decline could be observed at the time of the peak of the first wave in March 2020. In response to fiscal packages and liquidity stimulus, long-term inflation expectations returned to the pre-crisis level - on the other hand, a significant increase in long-term expectations above the pre-crisis level is currently not expected. For the UK, this means long-term inflation expectations of around 3.5%, in the USA of around 2% and in the euro zone of around 1%. In Japan - the economy with the longest history of quantitative easing by the central bank - long-term inflation expectations are around the zero line. At least in terms of long-term inflation expectations, we seem to have returned to normal. But there are some irritating signals in this context as well. The most important one is provided by the world's best macroeconomist: Dr. Copper. The world market price for copper has not only recovered by an astonishing 67% since the low for the year in mid-March, but is also indicating an increase of 25% for 2020 as a whole. Dr. Copper thus indicates an increase in real demand for non-ferrous metals, supported by an already improving economy in China. Incidentally, a similar picture is provided by the development of the world market price of iron ore, which could increase by approx. 52% on an annual basis in 2020. According to former U.S. Federal Reserve Banker Bill Dudley, this commodity price trend could provide what is likely to be a temporary price spike.

However, the long-term "game changer" with regard to inflation lies in the "output gaps" that have currently built up. This refers to the fact that economies are currently operating below potential due to high unemployment and insufficient factory capacity utilization. Second-round effects due to rising wages and salaries are therefore not an issue at present. This phenomenon may be one reason why the strong correlation between money supply and inflation postulated by Milton Friedman may be less strong, at least temporarily. According to current estimates, the global output gap is currently as high as 6% of global economic output - an incredible figure in a historical context. The recovery of the economies after the Corona pandemic will gradually reduce this output gap again. This process will take place on a regionally differentiated basis. From the current perspective, the growth prospects in China suggest the fastest reduction of this gap, followed by the USA and only with a delay in Europe. Only when these output gaps have been reduced - and only then - will inflation become a real issue

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